Scrutiny and Information Influencing

• In Event: Financial Reporting, Regulation and Expected Returns

Abstract

In this paper we investigate the effectiveness of imposing scrutiny to fight firms' information garbling. We study a setting in which both firms with good projects (which we call "good firms") and those with bad projects (which we call "bad firms") are able to influece the informativeness of their financial reports through their unobservable efforts, and examine the effect of imposing scrutiny to deter bad firms' garbling behavior. In our setting, scruitiny will be imposed if the outcome of the project is bad while the previously released accounting information about the project type was regarded as a good signal.
We find that imposing scrutiny based on the realized outcome and the previous accounting signal may not be efficient. In fact, under plausible conditions, it is optimal not to impose scrutiny at all. This is because scrutiny not only deters bad firms from garbling, but also hurts good firms by punishing them for "bad luck." In other words, a legitimate good firm may be accidentally punished if the signal is accurate about its type while the outcome unfortunately turns bad. In addition, scrutiny costs also discourage good firms from improving their information quality, as they are more vulnerable to scrutiny costs when the probability of obtaining an accurate high signal is higher.

Authors

• Lin Nan, Purdue University

• Xiaoyan Wen, University of Illinois at Chicago